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With Ottawa's finances looking up, provinces still feel the crunch

On Tuesday, Finance Minister Jim Flaherty's budget will show Ottawa is quashing its recession-fuelled deficit more quickly and painlessly than many had dreamed possible, thanks to better-than-expected economic growth in North America and the stronger revenue that comes with it.

But that sunnier outlook will mask a colder reality felt in several provincial capitals.

Gut-wrenching tradeoffs about what areas can absorb the deepest cuts, or what type of tax increases voters might tolerate to keep services ranging from health to transportation more or less intact, could be just around the corner.

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Most prominently, a major national accord on health funding, which sucks up more than 40 per cent of provincial budgets, is set to expire in 2014. Despite Ottawa's assurances that its contribution won't shrink, it is questionable whether the Harper government can maintain, let alone increase, its current 6-per-cent annual health transfer and still eliminate its own deficit by 2015-16, as it has promised.

"They are all faced with a health spending problem," David Dodge, the former governor of the Bank of Canada who was deputy minister at the Finance Department during the deficit-slashing mid-1990s, said of the provinces. "Expenditures are likely to be growing faster - potentially, significantly faster - than revenues will grow from current revenue sources."

Ontario and most provinces east of it face debt trouble, Mr. Dodge said, but how Ontario tackles its problem "matters to the country as a whole" because of its sheer size. Same goes for Quebec, to a lesser degree.

No province's spending crunch is as dire as in the most cash-strapped U.S. states, such as California and Illinois, and none is in immediate danger of a bond-market rout like the ones that forced Greece and Ireland into humiliating bailouts and an era of brutal austerity. Still, as Ottawa learned the hard way in the 1990s when markets started to lose patience with federal profligacy, those annual shortfalls that seem manageable while borrowing costs are low pile up and, eventually, the cost of servicing the accumulated debt can cripple a government's capacity to do much else.

The federal budget is expected to announce that Canada's 2010-11 deficit will have been less than the $45.4-billion forecast in October, and could point to a faster-than-expected track back to balance. But provincial deficits for the same period add up to just under $30-billion, so the federal fiscal picture dramatically understates the collective red ink across the country.

Already, the average amount of debt carried by provinces equals about a quarter of gross domestic product. Those with the biggest liabilities, like Ontario and Quebec, suffered disproportionately when the U.S. economy tanked in 2008, and still face the daunting challenge of trying to control spending and trim debt without the benefit of a stronger U.S. market, or the natural resources enjoyed by provinces like Alberta and Saskatchewan.

Adding another twist, the coming year could feature as many as seven provincial elections, pointing to an unprecedented pace of generational change among the premiers.

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It's possible that the potential lurch to the right in many provinces will make deficit-and-debt-control a defining issue that pushes existing finance ministers to hurry up and get their books in order. At the same time, analysts worry governments will bet that the key to staying in office is pushing the toughest medicine farther down the road.

Regardless of when they go to the polls, the race is on for governments to tackle their finances before interest rates rise, as economies around the world recover from the downturn, making those seemingly manageable debt loads more volatile. That could bring the issue to the front burner, which, as Bob Rae found out in Ontario in the 1990s, can be lethal for an incumbent.

Debt-rating agencies are watching three provinces closely.

Quebec won praise last year with a plan to tackle the debt and deficit, including through higher hydro rates. Last Thursday it won praise again for a budget that maintained a timeline of returning to balance by 2014, in part by increasing the province's notoriously low tuition fees and lifting contribution rates to its pension plan. But the latest budget also pencilled in a wider-than-expected deficit next fiscal year, and showed that Quebec's debt-to-GDP ratio - already the highest in the country - is now 54 per cent if you include pension-related obligations.

The very same day that Ottawa releases its fiscal plan, New Brunswick will deliver a budget that Conservative Finance Minister Blaine Higgs has warned will be the start of an aggressive, four-year effort to get spending under control. Mr. Higgs and his colleagues are well aware there is no easy route to firmer fiscal footing, having swept into office on a wave of anger over former Liberal premier Shawn Graham's poorly communicated and ultimately abortive attempt to boost provincial coffers by selling New Brunswick's hydro utility to Quebec.

A week later, Ontario Premier Dalton McGuinty, who faces voters on Oct. 6, will take another crack at keeping the bond markets and his Conservative challenger Tim Hudak at bay, by outlining how he intends to slay the province's massive deficit now that arbitrators have shown they won't play along with his voluntary wage restraint plan. Already, Mr. McGuinty has balked at Mr. Flaherty's call for provinces to get back into the black at the same time the federal government plans to, aiming instead for the 2017-18 fiscal year.

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Ontario is viewed as having more time because most of its debt is long term, so it is less sensitive to the short-term ripple effects of Bank of Canada interest rate increases - which could resume on the eve of the fall campaign. But that doesn't change the difficulty of the task ahead.

"The difference between now and, say, 20 years ago when Ontario was also faced with very large budget deficits, is we're unlikely to be skated onside by a manufacturing boom, a quick reversal in the U.S. economy and the tailwind of a relatively weak currency," said Doug Porter, deputy chief economist at BMO Capital Markets in Toronto. "This time will require more restraint."

Former federal finance minister John Manley, who now heads the Canadian Council of Chief Executives, recently urged Ontario Finance Minister Dwight Duncan to wage "war" on debt, arguing, "as events in Europe have made all too clear - investors don't have to buy your bonds," and, "If the market becomes jittery about your ability to repay, the interest burden will soar."

For now, foreign investors - drawn in by Canada's resources, Ottawa's better fiscal position compared with other advanced countries and a strong financial sector - continue to snap up Canadian bonds, including billions in debt issued by the provinces. Even Moody's, which in 2009 cut New Brunswick's rating - the agency's first such cut for a province in a dozen years - is reserving judgment on further downgrades.

"What we're looking for is a clarification of the steps they're going to take in order to achieve their fiscal plans," Jennifer Wong, an analyst with Moody's who specializes in provincial debt, said in an interview, adding the caveat that "the longer [the path back to balance]is, the greater the risk that you may not be able to follow that path."

Indeed, in an outlook released last week, Moody's warned the "magnitude of the task" and the prospect of several elections this year raise the risk that some provincial governments won't have the nerve to take the necessary steps.

And the long-term effect of that could be to drain Ottawa's finances, too. As the population ages and some provinces' labour force shrinks, so too will their tax base.

"We don't know what those transfer arrangements are going to be looking like after 2013," Mr. Dodge said, so "whether this becomes Ottawa's problem depends on what extent you think Ottawa is going to have to come up with the additional funds for health care, or whether that ends up being a purely provincial problem."

Mr. Flaherty has rung alarm bells of late, telling a business audience last month that tackling government debt is a "collective responsibility that must become a reality," while acknowledging that most provinces now have "clear time-frames and plans."

According to Conference Board chief economist Glen Hodgson - a former international debt specialist at the Finance Department - history shows markets don't get nervous about governments' ability to manage and repay their debts until it reaches about 80 per cent of GDP.

Add federal and provincial obligations together, though, and Quebec is already in that warning zone, with Ontario getting closer. As Europe discovered in spectacular fashion, shortfalls can't be punted forever.

"You can probably get to 100 [per cent]or beyond before markets really get worried, which is what happened to Greece last year," Mr. Hodgson said. Nonetheless, "this is the season in which we will expect governments everywhere to ensure that the stimulus is withdrawn, and that they put in place a plan that shows how they're going to get back to balanced budgets."

With reports from Barrie McKenna and John Ibbitson in Ottawa and Karen Howlett in Toronto

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